Being a small business owner comes with many challenges. You don’t just have to care about meeting your customers’ needs, getting paid and paying your suppliers. You must also take care to comply with federal and state laws and local guidelines. Small business owners, especially sole proprietors, face higher audit risk. The federal government believes that self-employed people grossly underreport their income and overreport their expenses. According to the online tax help website, “You may be surprised to learn that 20% of all small business audits involve disallowed deductions because the IRS reclassifies small businesses as hobbies under the so-called ‘hobby loss’ rule .” Section 183 of the Internal Revenue Code (nonprofit activities) limits deductions for nonprofit activities. IRC 183 is sometimes called the “Loss of Love Rule”. As a small business owner, it is your responsibility to ensure that your business is considered a legitimate business and not a hobby in the eyes of the IRS.
Below, I’ve listed some smart business practices that will not only help you define and grow your business, but also help you demonstrate that you’re running a real business and not just a hobby.
1) Write a business plan. There are many local small business support centers that can help you put your plan in writing. For example, the Small Business Administration has both local and online resources to help you.
2) Determine your legal structure (LLC, Partnership, C-Corporation, S-Corporation, Sole Proprietorship).
3) Obtain an Employee Identification Number (EIN) from the IRS.
4) Open a separate bank account for all your business transactions (deposits and fees). You need to keep your personal and business transactions separate.
5) Establish a separate line of credit or credit card to use for your business. Put personal expenses on your business card and business expenses on your business card.
6) Keep your business documents organized. The National Federation of Independent Business recommends keeping business records and receipts for at least seven years.
7) File complete tax returns on time. This will include all required time sheets and signatures. Depending on the type of organization you own, you or your CPA will fill out forms 1020, 1065, 1040 Schedule C, 1096, 1099, 940, etc. while calculating your self-employment taxes. I strongly recommend that you find a local Certified Public Accountant (CPA) who is familiar with your industry to help you determine which forms need to be filed and make sure they are filed with the correct government office on time.
8) Hire a support team: Attorneys can help you set up legal structures, and CPAs can help keep your finances in order and keep you in compliance with local, state and federal regulations.
9) Create industry standard business documents and forms including: logos, headed paper, business cards and websites.
10) Advertise in local media and appropriate trade journals.
Based on IRS document FS-2008-23, here are some questions the IRS may ask when determining whether your business is engaged in for-profit activities. You need to be prepared to answer these questions and provide documentation.
1) How many hours per week do you work at the company?
2) Do you rely on income from this activity to pay your bills?
3) Do you have what it takes to run a successful business?
4) Have you profited from similar campaigns in the past?
5) Is the activity profitable in certain years?
6) Do you expect the event to be profitable in the future?
7) Is there an element of personal entertainment or recreation?
8) Has your business been profitable for 3 of the last 5 years?
According to IRC 183, “If your business activity is not for profit, the allowable deduction cannot exceed the gross income from that activity.” The result is that your business deduction will now become itemized and limited to your hobby income.
For more information and assistance to help your company maintain its status as a legitimate business, contact a local CPA. Each state has its own separate licensing board. If you are located in North Carolina, you can contact the NC CPA Board website and click their “Licensee Search” button to find a CPA near you. All licensed and active CPAs in North Carolina can be found on this site.
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